Early Disposition of ISO Stock.
An explanation of selling ISO stock before the end of the special holding period.
When you exercise a nonqualified option you have to report and pay tax on compensation income. You don't report compensation income when you exercise an incentive stock option — and if you hold the stock long enough, you'll never report compensation income from that stock. Of course, you'll have to report a capital gain if you sell the stock for a profit.
There's a catch. If you don't hold the stock long enough, you've made a disqualifying disposition . You'll have to report some or all of your gain as compensation income, which usually means paying a much higher rate of tax.
Special holding period.
To avoid a disqualifying disposition you have to hold the stock you acquired by exercising your ISO beyond the later of the following two dates:
One year after the date you exercised the ISO, or Two years after the date your employer granted the ISO to you.
Many employers don't permit exercise of an ISO within the first year after the employee receives it. If that's the case you don't have to worry about the holding more than two years after the date your employer granted the option.
If you hold the stock long enough to satisfy this special holding period, then any gain or loss you have on a sale of the stock will be long-term capital gain or loss. You won't be required to report any compensation income from the exercise of your option.
If you fail to satisfy the holding period described above, your sale or other disposition of the stock is considered a disqualifying disposition. In this case you'll have to report compensation income as described below.
Disqualifying dispositions.
Everyone understands that a sale of the stock within the special holding period results in a disqualifying disposition. It's important to recognize that many other types of transfers can also result in a disqualifying disposition, for example:
A gift to someone other than your spouse. Using your shares to exercise another incentive stock option. Transferring your shares to an irrevocable trust.
Certain events do not give rise to a disposition for purposes of these rules, however:
A transfer that occurs as a result of your death. An exchange of shares that is part of a tax-free reorganization of the corporation that issued the shares (for example, certain mergers). A transfer that results from exercise of a conversion privilege (for example, converting preferred stock into common stock). A pledge or hypothecation (in other words, using the stock as collateral). A transfer that doesn't change the legal title of the shares (such as a transfer to a broker so the stock will be held in street name). A transfer of stock into joint tenancy (or a transfer out of joint tenancy, provided it goes back to the employee who exercised the ISO).
A transfer to a spouse (or to a former spouse in connection with a divorce) is a special case. This is not considered a disqualifying disposition. Following such a transfer, the transferee spouse is subject to the same tax treatment as would have applied to the transferor. The transferor spouse should provide records needed to determine when the special holding period will be satisfied, the cost basis of the shares and the value of the shares at the time the option was exercised.
Consequences of a disqualifying disposition.
The tax consequences of a disqualifying disposition apply in the year the disposition occurs. You aren't supposed to go back and amend the return for the year you exercised the option, if that was an earlier year.
If your disqualifying disposition is a sale of your shares to an unrelated person without a "replacement purchase" (see below), your tax consequences are as follows:
For a sale below the amount you paid for the shares, you don't report any compensation income. Your loss on this sale is reported as a capital loss. For a sale above the amount you paid for the shares but no higher than the value of the shares as of the date you exercised the option, report your gain on the sale as compensation income (not capital gain). If you sell your shares at a price that's higher than the value of the shares as of the date you exercised the option, you report two different items. The bargain element when you exercised the shares (the difference between the value of the shares as of that date and the amount you paid) is reported as compensation income. Any additional gain is reported as capital gain (which may be long-term or short-term depending on how long you held the stock).
If you had a disqualifying disposition from a transaction other than a sale to an unrelated person (such as a gift to someone other than your spouse, or a sale to a related person other than your spouse), or you bought replacement shares within 30 days before or after your sale, it's possible that the rules for that type of transfer don't permit the deduction of losses. If your disqualifying disposition comes from a type of transaction where a deduction for losses is not permitted, the following rules apply:
You have to report the full amount of the bargain element from when you exercised the option as compensation income. That's true even if the value of the stock has gone down since the date you exercised the ISO. If the transaction requires you to report gain (such as a sale to a related person other than your spouse), any gain that exceeds the amount of compensation income should be reported as capital gain (which may be long-term or short-term depending on how long you held the stock).

Learn About Incentive Stock Options.
Find out Form 3291 and How Employee Granted ISO Is Taxed.
Incentive stock options are a form of compensation to employees in the form of stock rather than cash. With an incentive stock option (ISO), the employer grants to the employee an option to purchase stock in the employer's corporation, or parent or subsidiary corporations, at a predetermined price, called the exercise price or strike price. Stock can be purchased at the strike price as soon as the option vests (becomes available to be exercised).
Strike prices are set at the time the options are granted, but the options usually vest over a period of time. If the stock increases in value, an ISO provides employees with the ability to purchase stock in the future at the previously locked-in strike price. This discount in the purchase price of the stock is called the spread. ISOs are taxed in two ways: on the spread and on any increase (or decrease) in the stock's value when sold or otherwise disposed. Income from ISOs are taxed for regular income tax and alternative minimum tax, but are not taxed for Social Security and Medicare purposes.
In order to calculate the tax treatment of ISOs, you'll need to know:
Grant date: the date the ISOs were granted to the employee Strike price: the cost to purchase a share of stock Exercise date: the date on which you exercised your option and purchased shares Selling price: the gross amount received from selling the stock.
Selling date: the date on which the stock was sold.
How ISOs are taxed depends on how and when the stock is disposed. Disposition of stock is typically when the employee sells the stock, but it can also include transferring the stock to another person or giving the stock to charity.
Qualifying dispositions of incentive stock options.
A qualifying disposition of ISOs simply means that the stock, which was acquired through an incentive stock option, was disposed more than two years from the grant date and more than one year after the stock was transferred to the employee (usually the exercise date).
There's an additional qualifying criteria: the taxpayer must have been continuously employed by the employer granting the ISO from the grant date up to 3 months prior to the exercise date.
Tax treatment of exercising incentive stock options.
Exercising an ISO is treated as income solely for the purpose of calculating the alternative minimum tax (AMT), but is ignored for the purpose of calculating the regular federal income tax. The spread between the fair market value of the stock and the option's strike price is included as income for AMT purposes. The fair market value is measured on the date when the stock first becomes transferable or when your right to the stock is no longer subject to a substantial risk of forfeiture. This inclusion of the ISO spread in AMT income is triggered only if you continue to hold the stock at the end of the same year in which you exercised the option. If the stock is sold within the same year as exercise, then the spread does not need to be included in your AMT income.
Tax treatment of a qualifying dispositions of incentive stock options.
A qualifying disposition of an ISO is taxed as a capital gain at the long-term capital gains tax rates on the difference between the selling price and the cost of the option.
Tax treatment of disqualifying dispositions of incentive stock options.
A disqualifying or nonqualifying disposition of ISO shares is any disposition other than a qualifying disposition. Disqualifying ISO dispositions are taxed in two ways: there will be compensation income (subject to ordinary income rates) and capital gain or loss (subject to the short-term or long-term capital gains rates).
The amount of compensation income is determined as follows:
if you sell the ISO at a profit, then your compensation income is the spread between the stock's fair market value when you exercised the option and the option's strike price. Any profit above compensation income is capital gain. If you sell the ISO shares at a loss, the entire amount is a capital loss and there's no compensation income to report.
Withholding and Estimated Taxes.
Be aware that employers are not required to withhold taxes on the exercise or sale of incentive stock options. Accordingly, persons who have exercised but not yet sold ISO shares at the end of the year may have incurred alternative minimum tax liabilities. And persons who sell ISO shares may have significant tax liabilities that aren't paid for through payroll withholding. Taxpayers should send in payments of estimated tax to avoid having a balance due on their tax return. You may also want to increase the amount of withholding in lieu of making estimated payments.
Incentive stock options are reported on Form 1040 in various possible ways. How incentive stock options (ISO) are reported depends on the type of disposition. There are three possible tax reporting scenarios:
Reporting the exercise of incentive stock options and the shares are not sold in the same year.
Because you are recognizing income for AMT purposes, you will have a different cost basis in those shares for AMT than for regular income tax purposes. Accordingly, you should keep track of this different AMT cost basis for future reference. For regular tax purposes, the cost basis of the ISO shares is the price you paid (the exercise or strike price). For AMT purposes, your cost basis is the strike price plus the AMT adjustment (the amount reported on Form 6251 line 14).
Reporting a qualifying disposition of ISO shares.
Reporting a disqualifying disposition of ISO shares.
Form 3921 is a tax form used to provide employees with information relating to incentive stock options that were exercised during the year. Employers provide one instance of Form 3921 for each exercise of incentive stock options that occurred during the calendar year. Employees who had two or more exercises may receive multiple Forms 3921 or may receive a consolidated statement showing all exercises.
The formatting of this tax document may vary, but it will contain the following information:
identity of the company that transferred stock under an incentive stock option plan, identity of the employee who exercise the incentive stock option, date the incentive stock option was granted, date the incentive stock option was exercised, exercise price per share, fair market value per share on the exercise date, number of shares acquired,
This information can be utilized to calculate your cost basis in the shares, to calculate the amount of income that needs to be reported for the alternative minimum tax, and to calculate the amount of compensation income on a disqualifying disposition, and to identify the beginning and end of the special holding period to qualify for preferred tax treatment.
Identifying the Qualifying Holding Period.
Incentive stock options have a special holding period to qualify for capital gains tax treatment.
The holding period is two years from the grant date and one year after the stock was transferred to the employee. Form 3921 shows the grant date in box 1 and shows the transfer date or exercise date in box 2. Add two years to the date in box 1 and add one year to the date in box 2.
If you sell your ISO shares after whichever date is later, then you will have a qualifying disposition and any profit or loss will be entirely a capital gain or loss taxed at the long-term capital gains rates.
If you sell your ISO shares anytime before or on this date, then you'll have a disqualifying disposition, and the income from the sale will be taxed partly as compensation income at the ordinary income tax rates and partly as capital gain or loss.
Calculating Income for the Alternative Minimum Tax on Exercise of an ISO.
If you exercise an incentive stock option and don't sell the shares before the end of the calendar year, you'll report additional income for the alternative minimum tax (AMT). The amount included for AMT purposes is the difference between the fair market value of the stock and the cost of the incentive stock option. The fair market value per share is shown in box 4. The per-share cost of the incentive stock option, or exercise price, is shown in box 3. The number of shares purchased is shown in box 5. To find the amount to include as income for AMT purposes, multiply the amount in box 4 by the amount of unsold shares (usually the same as reported in box 5), and from this product subtract exercise price (box 3) multiplied by the number of unsold shares (usually the same amount shown in box 5). Report this amount on Form 6251, line 14.
Calculating Cost Basis for Regular Tax.
The cost basis of shares acquired through an incentive stock option is the exercise price, shown in box 3.
Your cost basis for the entire lot of shares is thus the amount in box 3 multiplied by the number of shares shown in box 5. This figure will be used on Schedule D and Form 8949.
Calculating Cost Basis for AMT.
Shares exercised in one year and sold in a subsequent year have two cost bases: one for regular tax purposes and one for AMT purposes. The AMT cost basis is the regular tax basis plus the AMT income inclusion amount. This figure will be used on a separate Schedule D and Form 8949 for AMT calculations.
Calculating Compensation Income Amount on a Disqualifying Disposition.
If incentive stock option shares are sold during the disqualifying holding period, then some of your gain is taxed as wages subject to ordinary income taxes, and the remaining gain or loss is taxed as capital gains. The amount to be included as compensation income, and usually included on your Form W-2 box 1, is the spread between the stock's fair market value when you exercised the option and the exercise price.
To find this, multiply the fair market value per share (box 4) by the number of shares sold (usually the same amount in box 5), and from this product subtract exercise price (box 3) multiplied by the number of shares sold (usually the same amount shown in box 5). This compensation income amount is typically included on your Form W-2, box 1. If it's not included on your W-2, then include this amount as additional wages on Form 1040 line 7.
Calculating Adjusted Cost Basis on a Disqualifying Disposition.
Start with your cost basis, and add any amount of compensation. Use this adjusted cost basis figure for reporting capital gain or loss on Schedule D and Form 8949.

ISOs: Basics.
Disqualifying disposition is the legal term for selling, transferring, or exchanging ISO shares before satisfying the ISO holding-period requirements: two years from date of grant and one year from date of exercise. If you sell, transfer, gift, or short the stock too soon, you lose the tax benefits of ISOs that occur with a qualifying disposition. The timeline below illustrates the concept of the holding period, showing how long you must keep the shares to prevent a disqualifying disposition and make a qualifying disposition at sale.
Transfers of ISO stock to a spouse, to a broker (without change of legal title), in a divorce, or after your death are not dispositions. However, a gift to someone other than your spouse, including a transfer to an irrevocable trust, is a disposition.
Your company receives a tax deduction when you make a disqualifying disposition equal to the amount of ordinary income you recognize for your early sale. It needs to report this income on your Form W-2. Therefore, companies use various methods to track stock sales. These methods include mandatory sale reports, surveys, and even requirements to keep the stock in an account at a certain brokerage firm or transfer agent until the holding period is completed.
See a related FAQ with examples of the tax treatment when you engage in a disqualifying disposition.

Disqualifying dispositions incentive stock options

Subject: Disqualifying ISO Tax Q.
Date: Wed, 09 Feb 2000.
I have a question in regards to how to properly report a disqualifying ISO disposition that took place last year. On Dec. 12, 1999, I exercised X00 ISO and immediately sold the shares. The strike price was $XX.00/share. They were sold for $XXX. X0/share. The FMV of the stock on 12/16/99 was $XX0.00/share. My employer has reported $XX,000 ordinary income as a result of this disposition. However, I only received $XX, XX0. Do I record the $X. X0 share difference as a short term captial loss on schedule D?
You should ask your employer to issue a corrected W-2.
The ordinary income for the early exercise of an incentive stock option is the lesser of the excess of the fair market value at exercise or the gain on sale. (Section 422(c)(2).)